US fiscal stimulus under tax-cutting President Trump combined with rate rises and high growth should in theory have made the greenback stronger. Instead, the dollar is trailing other major currencies such as the euro and shows no sign of recovering yet.

“If we asked an economist to write a novel about the year 2017, it would probably feature two as-of-yet unresolved mysteries,” says Daalder, Chief Investment Officer of Robeco Investment Solutions. “The first would be the Curious Case of the Missing Inflation. The second is the Riddle of the Weak Greenback, since the US dollar has weakened between 5% and 15% against all of the major developed market currencies since the beginning of 2017.”

The US dollar has been the weakest currency over the past five quarters. Source: Robeco, Bloomberg.

“With momentum of the US economy picking up in 2017 and the Federal Reserve hiking interest rates by a full percentage point – practically the only central bank that is in proper tightening mode – this was not supposed to happen. So what is going on?”

Daalder says the weakness can be seen in the relationship between the two-year interest rate differential between the US and Germany, and the euro/dollar exchange rate. It was fairly well correlated until the start of 2017 – when Trump took office – after which it started to significantly diverge (see chart below).

So much for interest rates driving currencies. Source: Robeco, Bloomberg.

Comparisons with Reagan

“In theory, one would expect a country with a higher short-term interest rate to attract more capital flows, thereby boosting its own currency,” he says. “Although this is certainly not the only driver of a currency, since trade, geopolitics, tax changes and trade wars can all play a role as well, this has been a pretty reliable factor behind the currency moves over the past 10 years… until the start of 2017, that is.”

“But there are more reasons why the dollar should have risen. In theory, the weird macroeconomic policy mix that Trump has adopted since he took office should have sent the dollar flying. The combination of major tax cuts, monetary tightening by the central bank and trade restrictions is a policy mix that has a clear resonance with the policy pursued by President Reagan back in the 1980s.”

“During Reagan’s first year in office, the US dollar strengthened by 20% and had almost doubled in value by the time his first term was finished. Textbook economics would indeed conclude that tightening monetary policy, expansionary fiscal policy and trade restrictions call for a higher, not a lower, currency. Unlike what happened under Reagan, the dollar has weakened under Trump, thereby clearly ignoring this supposedly textbook outcome.”

Some possible explanations

Daalder says there are a number of possible explanations for the dollar’s counter-intuitive move. The first is the large and long-term structural US trade deficit, which means more dollars are being spent abroad than are earned at home, and would naturally weaken the dollar over time. A second is the relative valuation of a currency based on purchasing power parity; at the beginning of 2017 the dollar was the most overvalued of the major currencies, so maybe it has just corrected.

He also cites declining political concerns in Europe which have strengthened the euro. “Following the Brexit and Trump votes, it was feared that three key European elections in 2017 would lead to more populist victories in the Netherlands, Germany and France,” Daalder says. “But the populists did not manage to secure power, and political concerns eased, which helped to strengthen the euro. Although this may partially explain the strength of the euro, it does not help much in explaining the weakness of the US dollar vis-à-vis Norway or Japan.”

Predicting remains difficult

“Alternatively, it could be down to a loss in confidence in the US as a leading power following the election of Trump. As is more often the case, all of these arguments probably have some merit, with a combination of them leading to the result that we have seen – a weaker dollar.”

“Based on all these arguments, it should become clear that predicting where the dollar will go from here is a pretty difficult call to make. Trade, valuation, short rates, investment flows, politics, confidence: they can all be of secondary importance for years, largely ignored, only to all of a sudden take center stage.”

“And the erratic behavior of one of the lead characters (Trump) makes it even more difficult to come to a proper prediction. Not surprisingly, we currently do not have a very outspoken view on what the greenback will do from here onwards, although we do have a long position in the Japanese yen.”

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